If there is anything more sobering for a central banker than failing to meet the bank's mandates, as the European Central Bank arguably has, it is having one’s very legitimacy challenged.
The recent round of European Parliament elections were, if not a disaster for supporters of the euro project, resounding notice that many voters are deeply unhappy and suffering economically, with eurosceptic parties more than doubling their seats.
And given that an ECB-engineered weaker euro would help to shelter hard-hit euro zone workers and bring inflation closer to the bank's 2 percent target, that is exactly what we should expect.
How to interpret the vote? At the very least a substantial minority of EU voters are dubious of the sort of closer integration which is needed to prevent another crisis. And at the margin there is a small, but growing, rump of voters who seem to have had enough of the project entirely. In short, the ECB’s constituency includes many who feel they’d be better off with a different euro, a different currency altogether, or a differently constituted central bank.
To be sure, mainstream pro-European parties will still hold nearly 70 percent of parliament seats, and the results in Italy, where Prime Minister Matteo Renzi's centre-left Democratic Party scored a strong win, are somewhat reassuring.
Still, presiding, as the ECB does, over a currency zone in which so many are disenchanted, face declining living standards and the threat of falling prices, is an extremely strong argument for strong central bank action.
With any luck, that is exactly what we will get when the ECB meets on June 5, which may well result in both cuts in rates and perhaps a plan to help channel credit towards small and medium-sized businesses.
The ECB is of course unlikely to cite political disquiet as part of its reason for acting, but need not; the economic backdrop both justifies easing and provides a prime explanation for the unhappiness. Euro zone inflation has been below 1 percent since last summer, standing at just 0.7 percent today. A host of countries have prices which are falling outright. The central bank’s forecasts, which may well be optimistic, show inflation only getting close to the 2 percent target by the end of 2016. And while distorted by seasonal anomalies, first-quarter economic growth was only 0.2 percent, half the consensus forecast.
FIGHT WEAKNESS WITH WEAKNESS
ECB chief Mario Draghi himself gave perhaps the clearest signal yet on Monday that the bank was primed to move, citing the growing risk that falls in prices cause a self-reinforcing deflationary spiral.
"There is a risk that disinflationary expectations take hold," Draghi said at a conference in Portugal, prompting consumers and businesses to put off investment and consumption "in a classic deflationary cycle."
Draghi specifically cited the role of the euro in this, maintaining that its rise against the dollar over the past three years had driven down the price of energy and other commodities.
Taking deposit rates into negative territory might help to weaken the euro but from the signs in financial markets, Draghi is going to have to surprise either with action or words, to have much of an effect. The euro actually rose slightly on Monday in the wake of his comments and as traders digested news of the election.
At issue, ultimately, isn’t so much the destination for the euro zone, but the pace of change. High labor costs in parts of the euro zone which had previously been sheltered from competition are coming under intense pressure as countries like Italy and Spain are forced to reform their economies without recourse to their own currency which they can weaken.
“These less efficient sectors of insiders are coming under global competitive pressures especially with emerging market countries depressing their currencies,” Sebastian Galy, foreign exchange strategist at Societe Generale, said in an email interview.
“Too rapid an adjustment in unit labor costs creates a political backlash. One solution is to engineer a weaker euro or at least cap it, something euro hawks may now agree to.”
Simply slowing the rate of adjustment, as opposed to permanently sheltering uncompetitive sectors, can help the euro zone make the needed adjustments while at the same time building consensus for other reforms, such as banking union, which are desperately needed.
Many, inside and outside the ECB, would argue that greasing the skids for political change is not the job of a central bank. Strictly speaking that’s true, but neither is it the job of a central bank to force an overly disruptive downward move in living standards, especially given anemic inflation and growth.
Politics and economics for the ECB are clearly in alignment.
(James Saft is a Reuters columnist. The opinions expressed are his own)
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at email@example.com and find more columns at blogs.reuters.com/james-saft)
(Editing by James Dalgleish)